Economic reforms5 min read

The primary instrument of fiscal federalism is provided in Article 160 of the 1973 constitution. This deals with the National Finance Commission, the body responsible for formulating recommendations with respect to sharing federally mobilised resources between and among the federal and provincial governments.

This subject has evolved into its present form through different constitutions. It would be instructive to analyse how this evolution has taken place through the years as it will allow us to appreciate the distance that we have covered in a sensitive journey.

The starting point was the Government of India Act, 1935, the first constitutional document of British India. It is not surprising that the colonial administration was so possessive of its powers at the centre that only a very restricted set of responsibilities were transferred to the provinces and states, with frequent caveats that enabled the centre to interfere in provincial affairs. Finances were accordingly structured in a manner that only a fairly limited share was transferred to the provinces.

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The following taxes were declared to be collected at the federal level: (1) duties on the succession of property (other than agricultural land), stamp duties (on financial instruments), terminal taxes on goods or passengers carried by railway or air, and taxes on railway fares and freights; (2) tax on income (other than agricultural income) and corporation tax; (3) duties on salts and federal excise duties on manufactured and produced goods, except alcohol and opium; (4) custom duties, including export duties and taxes on the capital value of assets – other than agricultural land – of individuals and companies and taxes on the capital of companies.

There was no finance commission to deliberate on the division of revenue collected at the federal level. The act either declared certain proceeds to not be part of federal revenues or determined the manner in which it would be shared between the two governments. Thus the net proceeds of taxes (after subtracting the cost of collection) on the succession of property, stamp duties, terminal taxes on goods/people carried by rail or air, and taxes on railway fares and freights were to go to the provinces. Effectively, these taxes, therefore, were meant for the provinces but collected by the federal government.

With respect to taxes on income and corporation tax, a prescribed percentage of the net proceeds were to be assigned to the provinces. The act gave the federal government the discretion to decide the percentage. For taxes specified on salts and FEDs on manufactured and produced goods, assignments were contingent on an act of the legislature and the manner prescribed therein for transfers to the provinces.

In case the legislature didn’t decide, the proceeds remained with the centre. Meanwhile, the government could decide to share half or more of the duties on the export of jute, with the provinces making the exports. For all other taxes, including corporation tax and customs duties, revenues collected by the federal government weren’t required to be shared with the provinces.

Curiously, in all taxes shared with the provinces there was a proviso for the imposition of an additional surcharge whose proceeds were reserved exclusively for the federal government. Even where percentages were specified, lesser assignments could be made to the provinces if the federal government so desired. The federal government, in its discretion, could have provided resources to the provinces through grants-in-aid. For the provinces, the major revenue sources were land revenue, sales tax, forest and irrigation receipts, and mining receipts.

It may be noted that no guidelines were available for the horizontal transfer of assigned amounts among the provinces. It was again the discretion of the federal government to effect this distribution, both on account of tax transfers and grants-in-aid.

Evidently, the above model of fiscal federalism, despite being a significant advance from the days of the East India Company, was nevertheless reflective of a highly centralised constitution, consigning the provinces to the mercy of the federal government. The federal list contained 51 entries, many carrying multiple subjects. The concurrent list with federal primacy and residuary powers were also vested in the federal government.

Given the fact that the federal government was none other than the governor-general, representing the British Crown, securing the economics of the federal government was more paramount than those of distant local governments. What’s more, if locals looked up to the centre for its graces, their continued acquiescence with the alien rule was ensured.

It was later realised by the federal government that the act left many practical questions unanswered, and that without a judicious discourse fiscal federalism would face problems.

To this end, the government appointed a one-man committee in 1936, comprising civil servant and banker Sir Otto Niemeyer, with the terms of reference that sought recommendations on vertical and horizontal transfers of federally-collected duties and taxes mentioned above, within the framework of the act, and also for the need for grants-in-aid for those provinces that faced a deficiency in their finances. His report, titled ‘The Indian Financial Enquiry Report’, is also known as the Niemeyer Award that was effective during the period 1936-47.

The report made 69 specific recommendations for vertical and horizontal sharing of sharable taxes and duties, for grants-in-aid of the revenue and for debt relief in relation to the outstanding debts of the provinces to the centre. There were essentially two main recommendations: sharing income tax and export duties on jute.

For income tax, he recommended a vertical sharing of 50 percent between the federation and the provinces. He claimed that horizontal distribution among provinces was based on two factors: population (which was known) and the relative contribution of the province in collection in some reference year (estimated). Based on this, he determined a fixed percentage for each province.

Regarding the distribution of export duties on jute, the act envisaged that 50 percent or more of such proceeds could be given to the provinces contributing to such exports. Niemeyer recommended 62.5 percent of the proceeds for the provinces in proportion to their exports of jute. He also made specific recommendations for each province regarding grants-in-aid and debt relief.

To be continued

(This news/article originally appeared in The News on November 6th, 2018)